The Power of Rating Agencies

[CaptainPanic]

Credit rating agencies have been hot news since the economic crisis hit. Three agencies in particular seem very influential: Standard & Poor's, Moody's and Fitch, sometimes called the Big Three.

 

Some days, it seems that they practically rule the world.

 

Influencing the short-term political agenda

There are plenty of examples where a warning from one of the agencies triggered responses from the highest politicians in EU countries. (Links in Dutch (1, 2), and in English (3, 4)). Each article starts with a warning (not a real downgrade), followed by politicians who say something along the lines of "this shows that we need to take action", or "this shows how urgently we need to change our economy".

 

The articles all say the same: the credit rating agencies warn countries to change, or else. And because a downgrade costs billions (the interest rate will shoot up instantly), the credit agencies have countries by the balls... and this way they can set the agendas of governments.

 

Influencing the long-term political agenda

Even more worrying is that lately, the agencies have been influencing the democratic processes of countries in Europe (elections). In the Netherlands, our government collapsed rather unexpectedly. In the same week, S&P had warned us that our AAA-status could be downgraded (article in Dutch) if the government couldn't reach an agreement on budget cuts, or if the political differences would obstruct a healthy economic policy. In response to these warnings, our interest rate shot up. And although I cannot prove it, I have a feeling that this bullied some politicians into agreeing with new cuts... because our parliament reached an agreement very soon. And that's surprising given the fact that the government had just collapsed, and a new majority had to be found among parties, including the opposition.

 

They also responded to the French elections of last weekend, saying:

Standard & Poor's takes no political position regarding individual candidates or the outcome of any elections. Nevertheless, the policies of a country's government have a direct bearing on its creditworthiness. Our sovereign ratings therefore incorporate our view of the likely consequences to a sovereign's credit profile of policies adopted by its elected public officials. We will analyze the policy choices of France's president elect and the new government, taking into account the outcome of the parliamentary elections in June.

I'll summarize that for you:

They say that they take no position regarding individual candidates, but the results matter for the rating. In even simpler words, they say: "We don't care what you vote, but some votes may cost you your status, and therefore many billions of euros".

 

At least they have the decency not to be actively against socialist leaders (like France's new president)... but they already gave their warning. And the markets responded. It seems that the agencies accept higher taxes in combination with higher expenses... they still actively speak out against anti-cyclic spending.

 

The big worry

There are many different economic schools of thought. Differences between for example Europe and the US show that there is not a single perfect system. Europeans tend to be far more socialist, with a larger government, higher taxes, and larger government expenses... But we're equally rich as the US. It worries me that three American agencies can influence our economies so much, and apparently decided for us which economic school of thought is the correct one.

 

They seem to actively discourage anti-cyclic government spending. They simply say that they will lower the rating if the debt increases in the relatively short term... which is a clear message. The Dutch debt is only 66% of our GDP (compared for example to the USA's 103%). What do they care if our government decided to spend a bit more, to achieve some long-term goals, which is typically what anti-cyclic spending is meant to do?

 

Also, I seriously doubt that they have complete models for their predictions. Our governments might for example be encouraged to privatise some parts of the government. Do the analyses of the agencies take into account that this might not always be effective? Or are they only happy with the short-term inflow of cash into the national treasuries? And do they rate a euro spent on education the same as a euro spent on the military? After all, education can be called an investment, with (hopefully) a kind of payback time. The military, while necessary, is an expense. It's not gonna generate more money in the future.

 

In short: how do we know that the agencies are right?

 

The even bigger worry

The rating agencies are companies. They make a profit. How objective are they? What are their economic interests? Can they be corrupted? Can someone influence them to give a warning? Some prior knowledge of a press release by one of the agencies can be used to earn millions.

 

In short: can we trust them?

 

So...

I just wonder how it could happen that these three agencies can set the agendas of nations, influence elections, and make a nice profit at the same time?

[iNow]

Corruption and influence seem like probably answers. I wrote about something similar a while back when S&P downgraded the US. You can see that discussion here if you're interested: http://thescienceforum.org/topic35.html

 

To answer another question you asked (how do we know they're right), we really don't... and they're often wrong.

[John Cuthber]

I rather suspect that we know they are often right because they are a self fulfilling prophesy.

[CaptainPanic]

I rather suspect that we know they are often right because they are a self fulfilling prophesy.

Exactly. That's what upsets me so much. This self fulfilling prophesy gives them enormous power. They just have to drop a warning into the mainstream media, and the interest rates follow.

 

We always ask people to back up their claims on this forum. It upsets me that in mainstream media, nobody seems to ask S&P's to explain why they downgrade someone. So far, I haven't found them explaining which economic theories they've used, from which economic school of thought. I'm assuming they're followers of Keynes or something that descended from Keynes. But I'm not even sure about that.

[imatfaal]

I should put on record that I think the major rating agencies have performed dreadfully, and have been criminally complicit in multiple corporate collapses leading to real economic hardships for many. But the concept is not flawed and the lack of accountability / testability is not inherent IFF you believe the founding myth/philosophy of the free-market economy (which I do not).

 

1. Rating agencies do publish their reasoning in great details - but this is normally restricted to those who pay a lot of money for it. Unsurprisingly they tend to frown on customers who put all this information in the public domain; although vast amounts are freely available. There is an element of expert opinion involved - but it is the analysts knowledge, instintive understanding, etc that you pay for.

 

2. If you believe in the invisible hand of the market bollox then any ratings agency that consistently misreads the market will dwindle away due to lack of customers. many institutional investors are bound by rules (both internal and governmental) about the quantity/quality of the bonds/shares/risk they are exposed to. simplistically they will be forced to have a certain percentage in low risk/low yield and to not exceed a different percentage in high risk/high yield. if you the fund manager use a ratings agency that rates an instrument too high then your risk is higher than planned for, which counterparties who use different ratings agencies will penalise you for and this could lead to catastrophic failure. If you use a ratings agency that rates too low then you will be barred from investment in what would otherwise be areas with acceptable risk and high rewards. Basically it is the old chestnut - if the ratings agency don't get it right more often that not, and at least as often as their competitors, then they will go to the wall.

 

3. The self-fulfilling prophecy part is again only avoided if you believe the spin about the markets - stock market growth, economic national well-being is meant to be presaged on corporate/national strength, management, productivity and growth; ie good companies will succeed and bad ones will fail. If this were true then the ratings agencies would have only a minor temporary effect before the underlying reality of the market would move towards success and away from failure. Of course in reality John is correct; the markets now look more like a ponzi scheme with pension plans as the final layer of suckers who get screwed and investment quality has more to do with group-think and back-scratching than corporate strength.